How to save $34,000 in tax each year with a trust

It’s a tax trick usually used by the ultra rich but this hack could benefit everyday Aussies to the tune of $34,000 or more.

In Australia we pay a lot of tax, and while tax is important at some level, paying more tax means slower progress getting ahead with your money.

There are a lot of things you can do to be smart with your tax, but the single biggest opportunity for most people is how and where you invest.

Discretionary trusts

Trusts are a tax entity that gives you a lot of flexibility around your tax planning, and this is why they’re the most common tax structure used by people that have significant wealth.

Essentially how trusts work for investing is that you establish your trust, get it registered and get a tax file number, and once this is done you can invest money in the name of the trust. Once you have a TFN you can open bank accounts, share investing accounts, buy property, take out mortgages, or set up any other investments that take your fancy.

Once you own investments under (or inside) your trust, these investments will generate income and when they’re eventually sold there will be further income in the form of capital gains. This income is taxable, and the main rule of a trust is that the income needs to be distributed to another ‘beneficiary’.

Trusts are a tax entity that gives you a lot of flexibility around your tax planning. Picture: iStock

A beneficiary can be any individual, but the most common beneficiaries used are other family members. But you don’t just have to distribute investment income to other human beings, you can also distribute income to a Pty Ltd company (discussed below) which can save a serious amount of tax.

How investing through a trust typically works

You build investments through a trust by making an initial contribution of money to the trust, or regular deposits, or both to build up the money you have to invest inside your trust. The money is then invested, and generates an investment income that needs to be distributed each year.

If for example you set up a $2m investment portfolio in a trust that delivers you investment income in the next year of $100,000. You then need to decide which beneficiaries to distribute the money to.

Below I’ve included a table showing the different beneficiaries available to a family unit.

You can see that the difference between the highest and lowest tax rates is 47 per cent, which makes a huge difference to your investment return after tax.

The beauty of a discretionary trust is that each year you can change the beneficiaries each year, based on what will deliver the best after tax outcome. This allows you to optimise the after tax return across your family and investment entities each year into the future.

This flexibility combined with using a Pty Ltd company for investing is one of the biggest advantages of using a trust for your investing, and it’s a big part of the reason why this tax structure is the most popular for wealthy investors.

Pty Ltd Company

The most common form of company in Australia is an operating business, where you have an actual business that sells products or services. But companies can also be used for investment purposes, and because companies have a different tax rate to individuals this offers a tax saving opportunity.

Pretty much anyone can start a company, so long as you’re not on a government blacklist somewhere. You can do this all pretty easily online or with the help of a good accountant, and once you start a company you can apply for a TFN. Once you have this, you can open up bank accounts, investment accounts, and even buy property.

Investing through a company means that as opposed to you holding the bank account or investment in your personal name, it’s held in the name of the company and linked to the TFN of the company. Then each year the company needs to do a tax return where investment income is reported and taxed as per the company tax rules.

Pty Ltd companies pay a flat tax rate

Companies are subject to a flat rate of tax of 30 per cent, which is slightly lower than personal tax rates plus Medicare levy if your personal income is above $45,000 p.a., but significantly lower than the tax rate that applies in the higher tax brackets.

Importantly, because the tax rate of a company is a flat rate as opposed to our marginal tax rates that increase as your income increases, there are significant tax savings available at higher levels of income and wealth.

Below I’ve included an example showing different levels of income generated by investments in a company compared to income earned in your personal name, broken down into tax brackets.

You can see from these figures that where your tax rate and income is lower, the benefits of using a Pty Ltd to invest are low, and in some cases you’re actually worse off. But as your investment income and or tax rate increases, the benefits ramp up, pushing well into the tens of thousands of dollars each year, with a $34,000 saving on an income over $190,000.

This is why this structure is favoured by those that have (or are looking to build) significant wealth and investments.

These figures show that when you combine a Pty Ltd company with a trust, you create the ability to save a significant amount of tax.

The wrap

Getting the structuring of your investments optimised from a tax perspective will have a big impact on how quickly your money grows. You can see from the above that there’s a significant tax saving opportunity for people in the right position to leverage different tax entities for their investing.

That being said, any time you use any tax entity you need to make sure the benefit outweighs the cost of set up and management so you end up ahead. The rules around these tax structures can be complicated, and the impact on your money not just today but into the years ahead is significant. If you think this might be right for you, make sure you get some quality advice to ensure you get the results you’re after.

Ben Nash is a personal finance and investing expert commentator, financial adviser and founder of Pivot Wealth. Instagram | Facebook | Podcast.

Ben is also the Author of Replace your salary by Investing and Get Unstuck, and runs regular free online money education events, book your place here

Disclaimer: The information contained in this article is general in nature and does not take into account your personal objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstances before acting on it, and where appropriate, seek professional advice from a finance professional.